The Curse of Success, and Why Most Mutual Funds Fail Miserably

We spend a lot of time harping on mutual funds. Frankly, they deserve it. Most underperform their benchmarks and charge fees multiple times higher than passive index funds. The result is a giant wealth transfer from investors to fund managers.

But after speaking with a fund manager recently, I realize this story is more complicated than I've made it out to be. Mutual fund investors may only have themselves to blame for awful returns.

Most dismal mutual-fund returns are the result of managers engaging in the classic "buy high, sell low" dance. But those buy and sell decisions don't necessarily reflect the will of the investment manager. Fund investors are constantly adding to and withdrawing from the fund's they invest in -- almost always at the worst time possible.

"You would be surprised how easy it is for a fund's investors to take control of the fund," the manager told me.

Imagine you're a smart fund manager who thinks stocks are overvalued. You don't have any good ideas to invest in. But you come into the office one morning and your secretary says, "Congratulations, your investors just sent you another $1 billion." What do you do? You can:

Keep it in cash or bonds.

Close down your fund and refuse new investments.

Grit your teeth and buy overvalued stocks.

The first choice isn't even an option for some funds, as their charters mandate that they stay almost fully invested. Even if they can, bulking up cash dilutes the investments of existing investors. Fund managers rarely take this option -- equity mutual fund cash levels have fluctuated in a tight band of between 4%-6% over the last decade.

The second option is the noble choice, but rarely occurs because funds earn fees on assets under management. When a fund manager goes to his or her boss and says, "I'd like to turn down $10 million in annual fees," the results are entirely predictable. Greenwich real estate doesn't buy itself, you know.

Option three is usually what happens.

As Maggie Mahar writes in her book Bull!:

Everyone realized that as a fund manager, you were basically just a purchasing agent. As a purchasing agent, it was your job to put the money that showed up in whatever stocks your fund was supposed to invest in -- large-cap growth or technology or whatever. If you're a purchasing agent, price is not the issue ... you're like the produce manager in the supermarket -- you have got to have lettuce on sale the next day. No matter what the price. Maybe you can decide to buy the curly lettuce instead of the romaine. But the equity fund manager has to have stocks. You have limited control over what you're doing.

Now imagine it's 2009, and everything is going to hell in a handbasket. Stocks are the cheapest you've seen in your career, and the last thing you want to do is sell them. But you come into the office one morning and your secretary says, "Your investors want to withdraw $5 billion."

Source: WikiMedia Commons.

You only have one option to meet that demand: sell cheap stocks. Forget about all the buying opportunities -- your traders are working overtime to liquidate the portfolio whether you like it or not.

Sadly, that affects all of a fund's investors. Even if one fund investor has a long-term outlook and no intention of selling, the fund's buy and sell actions can be dictated by maniac deposits and panic withdrawals. Other investors' decisions can hurt you. That's why they call it a mutual fund.

For talented fund managers, this cycle is accentuated by "the curse of success." Once the media labels you a "star," investors are going to break down your doors and throw more money at you than you know what to do with. Then, once you have a bad year, they're going to rip it away as fast as it came in.

Take Bill Miller of Legg Mason. Miller was one the best investors in the 1990s and early 2000s before suffering huge losses during the financial crisis that sullied his long-term track record.

What happened? In part, he made some bad calls. But Miller's early success and media fame led investors to give him a net $4.4 billion in new cash to invest just as stocks were getting expensive last decade. As his skill came into question, they then yanked nearly $10 billion out just as stocks were the cheapest they had been in years. Miller's wisdom didn't really matter last decade. His investors were calling the shots.

Think of it this way, and Warren Buffett's success is likely due in part to Berkshire Hathaway's business model. As a public company, rather than a mutual fund, investors can sell Berkshire shares, but they can't take capital away from Buffet's hands. He's in control.

So, what do we learn from this?

One, be wary of celebrity fund managers. They aren't as adored today like they were in the 1990s, but every few years, about half a dozen fund managers grace the covers of the big finance magazines, get praised as geniuses on CNBC, and have buckets of money thrown at them. The results are almost always the same: eventual disappointment. The correlation between fame and regret in the mutual fund world is highly negative.

Two, this is a good reminder of how important it is to learn to invest on your own. Whether that's passively through index funds or actively by buying a portfolio of high-quality stocks, your money is ultimately your responsibility. Unless you want to leave the outcome in a stranger's hand, you need to learn the ropes and take control.

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Funny you should use Bill Miller as an example. I, too, gave him my money because of his glowing reputation as a great value investor. Not long after that the wheels started to fall off. One of his comments in his annual letter (yes, I actually read it) tipped me off to get out. I don't remember the exact wording, but it was something like "value is whatever I say it is". Luckily for me I got out before losing too much money.

Reading MF is like having a bible at hand. Before you all get too excited, let me explain. It seems that everything that happens that is bad, can be blamed on the investor. It is the investor who causes his/her trauma. Success always belongs to the "professionals."

I read MF precisely because I am not an investor. I don't even know how I would go about buying something on the stock market. The gambling mentality scares me. I think the market is a gamblers paradise, a legalized ripoff of the investing public. Rather than calling these people investors, why not be honest and call it legal (addictive) gambling?

Your article exactly is the kind of thing that frightens me off from this "investment" path. Is there an educated way to "invest" without all the myriad pitfalls that the hapless investor has to endure? Why is the typical reaction to state that it is simply "buyer beware," do due diligence, etc. when it is absolutely clear that no amount of due diligence protects the investor in the event of a fallout. It is always the bankers and Wall street that is protected by the legal system.

Don't get me wrong:; I would love to be an investor if the pa=laying field was level. But my house is paid for, my cars are my own and I have no debt. It is a struggle. But the alternative to the struggle is frightening for me.

This explanation from the fund manager you were speaking with is a bit of a red-herring concerning why the FUND might do poorly. It is quite relevant to the returns an individual investor in the fund might experience, but really should have no bearing on the returns of the fund itself.

The performance of a mutual fund is based on the calculation of its daily NAV, a time weighted rate of return that is independent of assets under management. You could double the money in a fund in a single day, and as long as the manager simply duplicated what was currently in the portfolio, and that purchasing did not distort the market price of the underlying stocks, then the NAV moving forward would be identical to what the NAV would have been if the extra funds hadn't been injected. Similarly, if half the fund were withdrawn all at once, if the manager paired all positions in half, and that selling didn't distort the market, then again the NAV would be completely unchanged going forward. So, unless the buying and selling is distorting the market, or the manager has to substantially reconfigure the relative holding composition when funds flow in or out, the measured performance of the fund should not be impacted.

What an individual experiences is much different, because rather than measuring their success as an abstract time weighted rate of return like the NAV, they get the equivalent of an internal rate of return that is dependent on when you put your money into the fund, and how much money you have invested during various times of differing performance. So, if twice as much money goes in when the fund is up, and gets pulled out when the fund is down, then those investors who moved their money in and out in such a fashion will take a large loss, but that is measured as a personal loss, and not as part of the fund performance.

There are two important take-away lesson as I see it: 1) Even if you are investing in a mutual-fund that ultimately turns out to have really good performance, you as an individual investor can sabotage your own results by moving your money in and out of that fund with poor timing, and 2) mutual funds with poor performance are not determined by funds flowing in and out unless the manager deploys them poorly by not duplicating or continuing with his/her current strategy.

Unless a manager can show that a rapid inflow or outflow of capital from their fund actually distorts the market price of their underlying securities then the excuse that their investor's behaviour has a significant impact on their fund's NAV performance is simply a comforting story they tell themselves.

Dollar cost averaging from bond index funds to stock index funds, both with good established track records. Throw in total reinvestment of dividends, plus the passage of time, and reap the rewards.--Tom Reilly

As usual, you wrote an excellent article. Very interesting. My only divergence with your articles is that I am an active fund fan and not much into indexes. If a person looks hard enough, there are a number of active funds that do a nice job compared to their benchmarks/indexes. Personally, the large majority of funds I own can go to cash as they see fit and that's fine with me. That's what I pay them for. The largest cash stake at present is Steve Romick with FPACX at 38%.

I do get tired, though, of people bringing up Bill Miller of Legg Mason Value Trust. His big claim to fame was beating the S&P for 15 straight years. Personally, I was never impressed by that since many of the years he beat by the slimmest of margins, and if the S&P lost 45% and your fund loses 44%, you technically beat the S&P but I don't consider that a positive. Many funds had much better total returns over that period of time. Plus, it was much too expensive for my taste. I do see your point using him though since he was a "star" manager.

I do love your articles though and you are one of the few "must reads" out there for me.

I certainly concur with RobertC3124's recommendation, since your well-considered differentiation between the performance of a fund and the returns that its investors realize provides a useful addendum to Morgan's article. However, I'm a bit hesitant about accepting your qualification---i.e., that a fund's inflows/outflows should have no effect on the fund's NAV "unless the buying and selling is distorting the market": if a fund's purchases/sales comprise a significant percentage of a security's float ( please don't ask me what that percentage might be), won't its actions necessarily move (i.e., distort?) that security's market to some extent? Too, even if we assume that any given fund's buying/selling of a security won't itself move or distort that security's market, can we justifiably extrapolate that there also won't be any such movement/distortion if scores of funds do likewise (as invariably seems to happen when the market experiences big moves up or down)?

I don't have your obvious background in finance, so please let me know what I might be missing here.

Mutual Funds by their definition are flawed. Group Think is one of those concepts taught in business schools that I never believed was the right way to go about things if you want to be the best, produce the newest, and be truly innovative. Group Think is where you take a consensus idea by everyone in a group which by default, that idea, is always going to be less and lower than the best person in that group. Mutual Funds can never be good investments because the fund is a Group Think result where the overall average return will never be as good as the best returning equity in the fund. Mutual funds will always be poor investments because whereas a portfolio might have Apple, they will also have some no-name tech company that has been in decline since forever.

The first above scenario is you get 1 billion in money and there is no place to put it because EVERYTHING is over valued? That is an impossibility!!! So right off the bat there is a screw up in thinking.

EVERYTHING is NEVER overvalued. If you do not have ANY good ideas where to place the money then you are in the wrong business.

If I were in this circumstance I would pick a preferred stock that pays a good dividend but does not fluctuate a lot and put the billion in it. Simple. Good dividend and EASY withdrawal.

You bring up a good point about stocks in general.... that is, when people move in and out of the market they tend to do so together. Not only do scores of funds have to buy/sell together, but thousands of individual investors do likewise. This is a major contributing factor to the level of volatility that we see in the market.

On thing this does not do, however, is affect a mutual fund's performance with relation to the market in general (i.e. when this tendency affects a mutual fund, it also affects the market). You might be able to make some argument about institutional ownership vs. independent ownership, but I doubt there is much solid evidence to back it up.

A couple parting thoughts:

(1) In 2011 the S&P500 gained 2.1%, while the average equity mutual fund investor lost 5.7% simply due to poor market timing

(2) For an account invested for 40 years, the final account balance will be 32% less if a 1% fee is charge (and 55% lower for a 2% fee) due to the effects of compounding. This number increases the longer the investing timeline.

You asked for advise and here it is. You have no choice except to invest in the market. There are no external gains to be made anywhere else. (savings, cd's, checking account). Inflation will eat it up.

All you need to know is that a preferred stock will be you a really good dividend every 3 months. Buy it through a broker and enjoy the dividend. That's it.

Try BAC-L. if you like 5.6%. This Bank of America preferred stock will be your salvation and the risk is minimal because they are to big to fail and backed by the United States Government.

In light of that, I have a neighbor who day trades and I have watched him go from a struggling, out-of-work father of 3 to a very wealthy man. He has been successful for about 7 years running now and I keep wondering if he will ever stumble. He just moved away to a gated community across town. He must have figured something out and he's not sharing the information with me.

Maybe those that know are saying nothing; and they don't need to get rich managing someone else's money as fund manager.

25 odd years ago when I was new to investing I decided to start by investing in mutual funds. After extensive reading of magazine articles I picked 5. I diligently put a few hundred a month into them until I had put $10,000 into each over the next few years.

I never took any money out so am able to compare the results of each. Today they range from a high of $215,000 in the high to $47,000 in the lowest. The other three cluster around $80,000.

I am sure style of the fund makes some of the difference in the results, but the quality of the fund manager must make a huge difference as well.

This explains why MF will move up and down with the market in general. It also explains why a manager can't consistently make crazy returns, and why smart HF managers turn away investors. It doesn't explain poor stock picking abilities, though. Yes, an index is not investable. A MF will have to hold cash for redemptions and will have to charge fees. But that doesn't explain why they consistently pick the most expensive stocks in an expensive market or sell the cheapest ones in a cheap one, does it?

Thank you Xander for the insightful clarification regarding mutual funds and their NAV.

With regards to comments about the fund manager can be negatively affected by market movements due to the liquidity of the stocks being purchased that might be a red herring as well. Isn't part of the reason you pay fees to the managers is because they have the expertise to mitigate these and other market risks? Perhaps they should use their judgement to invest in other stocks with similar characteristics or if they can't they should really close out the funds. By not doing so are they violating their fiduciary responsibility to their investors? Should they be excused for this?

If a fund has to sell stocks due to investors pulling out their money, it stands to reason that many other funds are doing the same in a market downturn. So it is likely that a fund manager's hands are tied to a large extent and he does not have the resources to take advantage of an oversold market. The same is true for an overbought market when investors are piling money into a fund to try and get in on good returns. I find it unlikely that these moves do not affect the underlying stocks that are being bought/sold, so it isn't something that is a red herring IMO. If the fund's performance is moving independent of the general market, then it's likely that poor management is the main case.

While it's easy to blame the fund managers for poor performance and claim that they are geniuses when they perform well, the fact is that the fund's investors play a major role in how well a fund performs. Since most of the general public is not adept at when to buy and sell, any mutual fund investor is going to see returns generated by poor investors.

I agree with the premise of this article, which to me is basically saying that you should get an education about all types of investment vehicles and take ownership of your investment dollars. Because you're not really putting your money into the hands of a fund manager, you're putting it into the hands of the poorly educated investors who are chasing a fund's returns.

If you put your money into a passively managed index fund during a period when stocks in general were overpriced then yanked it out when the bottom fell out you could obtain substantially similar results.